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August 29, 2012

As we continue our review of the proposed Basel III capital and risk-weighting rules, we have identified additional features of the proposed rules that may prove meaningful to community banks. One of the more significant changes provided by the Basel III proposal relates to the higher risk weights given to credit exposures (other than exposures to sovereign debt or residential mortgages) that are more than 90 days past due.

Under the current risk-weighting rules, there is no change in risk-weighting when an asset becomes 90 days past due, with all commercial loans, regardless of whether they are past due or paying as agreed, given a risk weight of 100%. However, under the proposed Basel III rules, the “portion of the [past due] exposure that is not guaranteed or that is unsecured” would receive a risk weight of 150%.

If the new Basel III rules had been in place during the last crisis, many banks could have found themselves in much deeper trouble earlier on in the cycle. With falling collateral prices resulting in more loans becoming unsecured, the increased risk weights assessed on high levels of past due loans would have resulted in lower capital ratios more quickly. However, considering the language of the proposed Basel III rules, would the existence of a borrower’s unconditional guarantee have been enough to avoid assessment of the higher risk weights? Although the letter of the proposed Basel III rules seems to create an exception from the new risk weights for fully guaranteed loans that are past due, recent regulatory guidance seems to undercut this reading.

In recent years, regulators have routinely disregarded unconditional guarantees for “collateral dependent” loans as part of their examinations, resulting in banks being required to impair and re-value many past due loans. With the advent of Basel III, it is possible that a bank would be required to also disregard an unconditional guarantee for the purpose of complying with the new 150% risk weights assigned to past due assets, which could further deteriorate asset quality and capital ratios. As such, the key to maintaining a lower risk weight on a particular loan will likely relate much more to loan-to-value calculations and careful valuations of the collateral pledged, rather than the existence of an unconditional guarantee in the loan file.